Opinion: You’re not going to like these predictions for mutual funds and ETFs

Most people making forecasts for 2017 are fessing up to how murky their crystal ball was a year ago, but when I looked back at my calls for 2016, it was the first time in 20-plus years that I pretty much got everything right.

The reason is that I look for the big future headlines in the mutual fund business, not in the broader financial-services industry or the world at large. In that narrow realm, it’s possible to look at trends and available information and make a savvy call. In most years, I get roughly three-quarters of my predictions right, with one forecast being a bit too early and another being the wild turkey of the group.

Thus, reading the proverbial tarot cards visible nowadays in the fund world, here are my predictions for the coming year — the big fund stories I expect to make headlines in 2017:

1. Continuing increase in fund and ETF liquidations and mergers:

According to investment researcher Morningstar Inc., the number of funds liquidated in 2016 was nearly double the level from a year earlier, while ETF closings were up 25%.

This even as the market kept up its long rally. Most experts are forecasting returns for 2017 that are low or flat — with gains concentrated in the first six months and balanced by setbacks thereafter. If the outlook for the market is ugly before Halloween, the fund firms that didn’t give up on their unloved and under-appreciated offerings in 2016 will take that step. Expect around 750 funds and ETFs to be dead by New Year’s Eve.

2. A blow-up in commodities ETNs, and a massive reduction in the exchange-traded note business:

The beginning of 2016 saw some moments when commodities notes such as iPath S&P GSCI Crude Oil Total Return ETN
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were completely disconnected from the action of oil prices, trading at premiums rather than fair value mostly due to back-room technical reasons. The end of 2016 saw trouble for leveraged exchange-traded notes, with Velocity Shares de-listing a few issues — and then creating and re-issuing brand new replacements — leaving investors confused and mistrustful.

Exchange-traded notes are a cousin to exchange-traded funds, but they are not the same and their different structure comes with inherent, problematic flaws. The weird setup is precisely why many backers now want out, and many investors never want to be in them; those feelings will only intensify this year as trouble surfaces in some commodities offerings.

3. A “liquid” fund has a liquidity crunch:

Liquid-alternative funds have been increasingly popular in the business in recent years, their potential downsides largely overlooked … until now. Despite their name, liquid-alt funds often hold securities that aren’t so fluid; that’s not a problem, unless there’s a need to cash out of securities in a hurry.

With the Fed hiking rates, you can expect increased volatility. That, in turn, makes investors jumpy. If they get antsy and want to pull too much from a liquid-alt fund, those redemptions could force sales at just the wrong time, at which point investors learn the difference between what is “liquid” and what is “easily sold without affecting the price.”

Funds will either lock investors in — trying to prevent losses — or let them suffer. Either way, the pain is real.

4. Disappointed bond fund investors:

It’s not a surprise that stocks have outgained bonds over the last five years. The bigger issue is that the 10-year Treasury
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low hit in July 2016 has been cited by several experts as the potential end for a bond bull market that has run for 35 years.

While bond funds will not crater this year as rates rise — something experts were worried about a few years ago — bond-fund returns are not likely to keep up with recent levels of success.

5. A big increase in unpleasant tax surprises:

The rally in late 2016 helped push back a tax problem, but unless the market is stronger than anticipated and volatility is lower than expected, funds are going to generate large taxable distributions as they react to changing market conditions.

Distributions don’t feel like a problem in good years when funds post big gains and taxes feel like a cost of doing a profitable business.

In a market reversal, decline or a flat/low-single-digit year, however — and especially if increased volatility pushes managers to sell into apparent trouble — funds may generate tax bills that equal or eclipse their growth; investors won’t be happy with oversized tax bills on mediocre results.

6. The 10-year flat-line:

With most investors focused domestically, it has been easy to ignore the fact that foreign markets could get to the end of this year and wind up showing a lost decade, a 10-year stretch where the average fund was flat or down, on average, since before the financial crisis started.

Look at a 10-year chart on emerging markets, for example, and it’s clear that if the average fund can’t put up gains of about 25% by the end of October, the entire asset category will be showing a decade when it was under water.

Accordingly, when people preach to “buy domestic” this year, a big weapon they will be using come the fall is the talk of a lost decade in some international markets.

7. Investors give up on diversification at just the wrong time:

Over the last few years, allocating assets across different investment types hasn’t really worked; investors would have benefitted mostly from keeping the bulk of their holdings in big domestic stocks.

That has led to frustrated investors moving away from the traditional diversified portfolio to a factor-investing approach, which typically means they are pursuing whatever has worked lately.

The one certainty for 2017 is uncertainty; fallout from the U.S. presidential election and the Brexit vote in Great Britain — and political nervousness around the world — hasn’t really hit home yet. It might turn out good or bad, but it won’t show up in markets until late in the year. Meantime, there is substantial headline and volatility risk, and diversification helps to soothe those savage beasts … provided you stick with it.

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